Budget Deficit Financing and Exchange Rate Volatility in Kenya

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Abstract

This study was motivated by over a quarter of a century of exchange rate volatility, the
persistent problem of budget deficit in Kenya, and the importance of the two in the economy,
which explains their inclusions in the convergence criteria for the East Africa Community.
Exchange rate volatility exposes the participants of international markets to the risk of loss
and thus disturbs the optimal allocation of resources. Despite effort made by past studies to
explain exchange rate volatility, there exists controversy in their findings, with a counterargument
being provided for each assertion. This study attempted to improve on the
modelling of volatility in exchange rate in order to best explain its movement. This was done
by analysing the effects of using the financing composition of budget deficit instead of
budget deficit in modelling of exchange rate volatility. Thereafter, the model that provided
the best fit and forecast were applied to determine the effects of budget deficit financing and
macroeconomic fundamentals on exchange rate volatility under different exchange rate
regimes. Monthly data spanning the period 1973:01 to 2005:12 for the following variables:
exchange rate volatility, interest rate differential, inflation rate differential, domestic nominal
interest rate, money supply differential, net foreign assets and productivity differential were
used to achieve these objectives. The study tested for structural breaks and aggregation of
variables problem then applied the VAR estimation technique to the model which offered the
best fit. VAR results were used to explain the effects of macroeconomic fundamentals on
exchange rate volatility. The results of impulse response functions and variance
decomposition revealed that shocks to productivity differential, inflation rate differential, and
to a lesser extent, the interest rate differential and the net foreign asset are the main drivers of
exchange rate volatility in Kenya. The analysis of the results revealed a stronger medium- to
long-term causality linkage from macroeconomic volatility to exchange rate volatility than
the other way around. This was evidenced by bidirectional causalities between productivity
differential, inflation rate differential, and to a lesser extent, the interest rate differential on
one hand and exchange rate volatility on the other. The net domestic financing of budget
deficit had positive effect, while the net foreign financing of budget deficit had negative
effect. The study concluded that there is no aggregation problem in budget deficit. However,
the model with the financing composition of budget deficit provided the best fit and the
macroeconomic fundamentals successfully explained exchange rate volatility.